The biggest danger for DIY investors is not a lack of intelligence. It is a lack of process.
Without rules, investors often buy after prices have already risen, sell after prices have already fallen, concentrate too heavily in familiar companies or mistake activity for progress. This risk can catch institutional investors, too, especially those that have built their performance series or reputation on just a few great moves. Those records aren’t wrong for sure, but they do suggest that similar results in future periods could be harder to accomplish or more volatile. Breadth is important, but that is for another article.
Moving back to rules, behavioral finance explains why investors can be vulnerable. Potential biases (we all have them at some level) include loss aversion, overconfidence, herding and familiarity. There are dozens of others.
There’s no way to ‘get around’ behavioral biases, but there are ways to dampen their impact with a set of rules such as the septuplet we offer below.
Mistake 1: Buying a Story Instead of a Business
A compelling story is not the same as a compelling investment. A company may be described as the next big thing, a promising growth stock, all the rage or too cheap to ignore.
A wonderful company can be a poor investment if purchased at an unreasonable valuation. Conversely, a dull business can produce attractive returns if bought at a sufficient discount to expected fair value.
The market does not reward investors for identifying a good story. It rewards them for paying a sensible price relative to future cash flows.
Our rule: Translate the story into numbers. This could be a lengthy investment process with qualitative and quantitative work, or it could be a more elementary checklist that helps identify easily missed points.
Mistake 2: Confusing a Falling Stock With a Bargain
A lower stock price does not automatically mean a better investment. Sometimes a stock falls because the market has become excessively pessimistic. Other times, it falls because the company is worth less than investors previously believed.
This distinction separates a potential opportunity from a Value trap.
A falling price creates a question, not an answer.
Our rule: Recalculate intrinsic value after a major decline
When a stock falls sharply, we do not automatically average down. We revisit the original thesis.
A lower price is attractive only when the underlying value has remained stable or when the decline in value is smaller than the decline in price.
Mistake 3: Trading Too Frequently
DIY investors often believe they need to act in order to make progress.
They monitor every price move, react to every headline and constantly search for the next opportunity. This creates the appearance of control, but frequent trading can introduce several potential problems, including higher taxes in taxable accounts, high transaction costs (or spread), exposure to emotional decision-making and reducing the time for a thesis to develop.
Our rule: Every trade must answer “Why now?”
If the only reason to trade is that the stock moved, the correct response may be to do nothing.
Mistake 4: Building a Portfolio Around Conviction Alone
Conviction is valuable. Overconfidence is expensive.
An investor may become so confident in one company, industry or theme that a large portion of the portfolio depends on a single outcome. The business may be high quality, but unexpected events can still cause permanent losses.
Diversification cannot eliminate losses, but it can reduce the damage caused by a single mistake. The Securities and Exchange Commission describes diversification as spreading money among different investments to reduce risk, while also noting that diversification does not guarantee gains or eliminate losses.
Our rule: Diversification is the only free lunch in investing.
Position sizing is a form of risk management. It allows investors to be wrong without allowing one mistake to permanently impair the portfolio.
Mistake 5: Ignoring the Portfolio as a Whole
Many DIY investors evaluate stocks one at a time.
They ask whether Company A looks attractive and whether Company B appears undervalued. But they may not ask how those investments interact with one another.
A portfolio can contain 20 stocks and still be highly concentrated if most of them depend on:
- The same economic cycle
- The same interest-rate environment
- The same commodity
- The same customer group
- The same geographic region
- The same technology
- The same market factor
Owning several companies is not the same as being diversified.
Our rule: Review exposure by risk, not just by ticker
Review the portfolio by:
- Sector
- Geography
- Market capitalization
- Currency
- Growth versus value exposure
- Cyclical versus defensive businesses
- Debt sensitivity
- Customer concentration
- Top 10 holdings
- Cash and fixed-income allocation
- Relative position
The objective is not to create a portfolio that never declines. That does not exist. The objective is to avoid a portfolio whose outcome depends on one narrow prediction.
Mistake 6: Chasing Performance
A stock that has risen sharply attracts attention.
Investors see the gain, read the success stories, and begin to wonder whether they are missing out. By the time they buy, the original opportunity may have disappeared.
Performance chasing is especially dangerous because it feels rational. Investors are not buying randomly. They are buying something that has already worked.
The fact that an investment has performed well does not tell you whether it remains attractively priced today.
Our rule: Separate business performance from stock performance
A rising stock deserves a fresh valuation, not automatic admiration. Strong businesses can remain good investments after rising. But the analysis must begin again.
Mistake 7: Having No Written Selling Rules
Buying is exciting.
Selling is where discipline is tested.
Without clear selling rules, investors often hold losing positions indefinitely because they do not want to admit a mistake. They may also sell winning investments too early because they fear giving back a gain.
Both decisions can damage long-term results.
A stock should not be sold simply because the price falls. Nor should it be held simply because the investor already owns it.
Our rule: Sell for a reason tied to value
Avoiding Common DIY Investing Mistakes
Our experience is that investing works best when independence is matched with discipline.
We believe that the fewer decisions you make impulsively, the more likely your results will reflect the quality of your ideas rather than the intensity of your emotions
Important Information
This article is provided for educational and informational purposes only and reflects our views and investment philosophy. The investment principles, practices and observations discussed are not guarantees or predictors of investment success, and there can be no assurance that following them will result in profitable investment outcomes.
Investing involves risk, including the possible loss of principal. No investment strategy or approach can eliminate investment risk or assure a profit. Diversification may help manage certain risks but does not ensure a profit or protect against loss in declining markets. Investment decisions should consider an investor’s individual objectives, circumstances, risk tolerance and investment horizon.
Investment analysis involves judgments, estimates and assumptions that may prove incorrect. Assessments of valuation, fair value, business quality, competitive advantages, portfolio risks and other investment characteristics are subjective and may change as market, economic, company or other conditions change. An investment considered attractive based on these or other factors may decline in value or result in a loss.
Past performance is not indicative of future results. A security’s prior price performance, whether positive or negative, does not assure or predict its future performance. Market prices may differ materially from estimates of fair value, and there can be no assurance that an investment will ultimately trade at or near an estimated fair value.
Information obtained from third-party sources, if any, is believed to be useful for the purposes used but has not necessarily been independently verified. We do not guarantee the accuracy, completeness or timeliness of third-party information, and such information may change without notice.
